LSE-Deutsche Börse: Winter is here!

Will the deal survive post-Brexit?

We have all heard executives at both companies tout the benefits of this marriage: creating a global derivatives powerhouse to rival the Intercontinental Exchange (ICE) and CME Group; becoming a leader in post-trade services, and of course a pioneer in market data as the combined entity would own the FTSE Russel, STOXX, and DAX indices.

However, the question on everybody’s mind remains: how will the UK’s historic vote to leave the EU weigh in on the deal? The risks are nothing short of real as executives reiterated ad nauseam in the days following the referendum that the deal will continue as planned. We are not so sure.

In our report published last week, we urged the shareholders of the London Stock Exchange to vote against the merger at the meeting which will be held on the 4th of July. Chief among our concerns was the fact that the deal did not value the LSE at a premium. Case in point is the proposed price of 2,554p/share which was actually at a discount to the unaffected share price on March 15, 2016. In an industry with historic takeover premiums to the tune of 30 to 40%, this ostensible ‘merger of equals’ belies the fact that Deutsche Börse (DB) may lack the financial resources to pay such a premium as noted by market analysts.

Interestingly, for an asset that has been the target of several takeover attempts over the last decade, the Board’s approval of a merger without a premium comes as a surprise and calls into question whether proper due diligence was performed. Providing fodder for our concerns is the fact that this is the third attempt at a merger between LSE and DB. Their first dalliance back in 2000 ended when OM Gruppen (operator of the Swedish stock exchange) made a £808 million bid for LSE which was rejected by the company in August of that year. The Germans renewed their efforts in January 2005 by making another cash offer for LSE, this time valued at £1,300 million. Again, the Board rejected this offer claiming that it did not reflect the inherent value in their business. Over the years, DB was not the only interested suitor: LSE has also rejected bids from Australia’s Macquarie Bank (£1,600 million in December 2005) and NASDAQ (£2,700 million in November 2006). The current merger proposal values LSE at £8,913 million.

We note that ICE considered making a counterbid for LSE in February of this year and there were rumours that even the CME was preparing a bid in what was shaping up to be a Game of Thrones showdown for control over the London exchange. However in May of this year, ICE abandoned its bid citing that LSE executives refused to discuss a buyout, a claim that the company denies. Given the evident attractiveness of LSE to foreign suitors, we urged the Board to demonstrate that it has conducted an exhaustive search for options and prove whether this transaction is truly in the best interest of LSE shareholders.

Even before the so-called ‘Brexit’ vote, European officials publicly expressed their reservations over the deal as pride played a role with officials in both London and the Continent raising concerns over the potential loss of status as a financial hub. French Finance Minister, Michel Sapin, called into question the merits of the deal citing competitive concerns in European financial markets. In this vain, he claimed that the combined entity would be too dominant and could potentially dwarf competition from rivals such as Euronext. Joining the crowd of influential dissenters is Felix Hufeld, the president of the Federal Financial Supervisory Authority or BaFin, Germany’s financial markets watchdog. Earlier this week, in reference to the combined entity’s London HQ, he emphasized that “it is hard to imagine that the most important exchange venue in the euro zone would be steered from a location outside the EU".

A key argument for the merger’s champions is the cost and revenue synergies post-closing. Whereas they were higher than anticipated by the market, we are concerned as to whether they can be actually achieved with London leaving the EU. At the core of the cost synergies is the harmonization of post-trade platforms (50%) and a combined cost centre (30%). Should the parties to the merger face two different regulatory regimes and be forced to maintain their existing management structures, it becomes abundantly clear that these synergies may not be realised. Moreover, revenue synergies may run into significant roadblocks should the UK and EU fail to negotiate a suitable ‘passporting’ regime that would ensure uninterrupted access to European markets which was the norm pre-Brexit.

Heightened uncertainty does not bode well for the merger and only serves to reinforce our reservations regarding its merits. As we move into unchartered territory and volatile markets over the coming months and even years, executives are in the unenviable position of singing the deal’s praises to both sceptical investors and wary regulators alike. We here at ECGS will not be holding our breath.

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